THE ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS

The result of dividing one financial statement item by another is called a financial
ratio. Ratios help analysts interpret financial statements by focussing on
specific relationships.

It is possible to compute an unlimited number of ratios from the financial statements.

However, this would be of no use. The user of financial statements has to compute
only those ratios which are suited to his needs and which represent meaningful
figures.

These ratios are then compared with similar ratios of:

 a different reporting period of the entity
 another similar entity for the same reporting period
 industry average ratios
The user then needs to analyse them and interpret the results. Analysis of ratios is
not an exact science; there can be no hard and fast rules. The analysis and
interpretation will depend upon the circumstances of each entity.

Purpose of interpretation of financial statements

The purposes of interpretation of financial statements are as follows:
1. To measure the profitability of the business:
Interpretation of financial statements helps in ascertaining whether adequate profits
are being earned on the capital invested in the business or not. In this way banks
and other financial institutions are assured that their money is safe and they will also
earn a satisfactory return on their investments.
2. To analyse the past trend:
The purpose of interpretation of financial statement is to indicate the past trend in
various items of financial statements. For example the gross profits have increased
over a period but the net profit has declined. This will help the entity to concentrate
on operating expenses and frame suitable budgets to control them.
3. To evaluate the growth potential of the business:
The purpose of interpretation of financial statement is to provide sufficient
information to management regarding the growth potential. This will help
management to take decisions regarding expansions or improving capacity.
4. To do comparative study of firm’s position in relation to other firms in the
industry:
The purpose of interpretation of financial statement is to help the management in
making a comparative study of the profitability of various firms engaged in similar
businesses. Such comparison also helps the management to study the position of
their firm in respect of sales, expenses, profitability and utilising capital, etc.
5. To assess overall financial strength of business:
The purpose of interpretation of financial statement is to assess the financial strength
of the business for taking important business decisions. For example decision to
purchase new machines or whether to issue shares or avail a loan, etc.
6. To examine solvency of the business:
The purpose of interpretation of financial statement is to assess whether there is
adequate liquidity in the entity. This includes short-term and long-term liquidity.
Factors on which analysis and interpretation of financial ratios depend
include:
the size of the business
the state of the economy
the policies of management
the company philosophy
the industry norms
government rules and regulations

Financial statements by themselves reveal only partial information about the

performance, liquidity, gearing etc of an entity. They provide all the basic required
financial data of an entity for a period or as at the end of the reporting period.

Analysing this data in order to help the user obtain relevant information is the
function of accounting ratios and ratio analysis.

Accounting ratios and ratio analysis is the key to analysing and interpreting financial
statements. They add life to a set of numbers in such a way that numbers reveal
those
details which even words would find difficult to reveal.

Problems of using historic information to predict future performance and

trends

Money value changes

The value of money changes continuously. Owing to this limitation, the value that
was recorded a few years ago is less relevant today and is likely to be even less
relevant next year.
Because of the decline in the value of money, the financial statements lose their
utility as an index of current economic realities.
Inherent limitations of financial statements
The limitations inherent in the financial statements are transferred to predictions
based on those statements.
The following are the limitations:
1. Even though financial statements tend to give an appearance of finality, the
historical costs of assets reflected in them may not represent either their realisable
or replacement value.
Thus, if future predictions are based on the existing figures, they are also likely to
suffer from the defect of being unrealistic.
2. There are many non-monetary factors that affect the future of the business as
much as the assets and liabilities in the statement of financial position.
Element of uncertainty about future
Whatever planning or projections we make, there is always an element of uncertainty
involved.
Limitations of assumptions, estimations, and the model used
The assumptions made while projecting the future may not come true.
Estimates and judgements
The accounting process records not only transactions with precise amounts but also
estimates. When it comes to estimates, there is always a subjective element. Wrong
estimates may be used to manipulate the accounts.
Failing to apply the IFRS or applying them in an incorrect manner
The IFRSs lay down various rules for different areas of accounting. An entity is
expected to follow these meticulously. At times, an entity may follow a wrong option
or implement an option in an incorrect manner.
Omitting important information
A large asset is impaired, but carried at historical cost in the statement of financial
position, and the fact is not disclosed. If the fact of the impairment is disclosed, the
user gets correct information.
1) Inconsistent definitions of ratios (what is included or excluded)
2) Financial statements may be manipulated deliberately
3) Different companies may adopt different accounting policies
4) Different policies given to eg different customers (eg credit terms) which
change the ratios
5) They are calculated at a point at the year end, which may not be reflective of
the company’s usual trading cycle
Classification of financial ratios
Financial ratios are useful to a variety of users for different purposes. Financial ratios
may be classified according to the motive to use the financial ratio i.e.
to analyse whether company is profitable
to analyse the company’s liquidity status
to analyse if the company can meet its tax liability
to analyse if the company can repay its debt
to analyse whether the company is performing well and using its resources
efficiently
to analyse whether the company meets the expectations of shareholders

Ratios can be broadly classified as follows:

A. Profitability ratios
1. Gross profit Gross profit X 100 Reflects gross margin
margin Sales revenue made on sales
2. Operating Operating profit X 100
Reflects operating
profit margin Sales revenue margin
made on sales
3. Net profit Net profit (PBT) X 100 Reflects net margin
margin Sales revenue made
on sales
4. Return on Operating profit Reflects relationship
Capital Capital employed X between profits earned
employed 100 and
size of company
(measures
overall performance of
company)
5. Return on Operating profit X 100 Reflects relationship
assets Total assets between profits earned
and
total assets

B. Liquidity ratios
1. Current ratio Current assets Measures ability to pay
Current liabilities current liabilities from
the
current assets
2. Quick ratio Quick assets Indicates the ability to
Current liabilities pay
all current liabilities if
they
become due for
payment
immediately

C. Efficiency ratios
1. Asset Sales revenue Shows how much
turnover Total assets revenue
(times p.a) generated by a $1
 worth of
assets
2. Inventory Cost of sales Indicates how many
turnover Inventory times
(times p.a) the inventory is being
turned over in a year
3. Receivable Receivable Reflects the number of
days Credit sales X 365 days it takes for a
days customer
to pay
4. Payable days Payables Reflects the number of
Credit purchases X days it takes for a
365 days company
to settle its bills
5. Working Inventory turnover Approximate number of
capital cycle days + days it takes to
Receivable days - purchase
Payable days the inventory, sell the
inventory and receive
cash.

D. Financial position
Ratios
1.Capital gearing ratio Total long - term debt It expresses the
Shareholders funds X relationship between a
100 company’s borrowings and
its own funds
2. Debt ratio Total liabilities Indicates the percentage of
Total assets assets financed with debt
3. Interest cover Profit before interest Indicates the number of
and tax times, the profit covers the
Interest expenses interest charge

E. Investment/shareholder ratios
1. Earnings per Net profit after interest and tax and preference
share (EPS) dividends
Number of ordinary shares issued
2. Price/earnings Market price per share
ratio (P/E) Earnings per share
3. Dividend yield Gross dividend per share
Market price per share
4. Dividend cover Net profit after tax and preference dividends
Ordinary dividends paid and proposed